Thursday, August 23, 2007

Can high liquidity + low volatility = high risk?

Lower volatility can mean higher risk. Here is how I think we get to this paradoxical result.

With the growth of hedge funds over the past few years, more and more capital has been scavenging for alpha opportunities. When anything moves a little out of line, there is plenty of money ready to pounce on it. That is, there is more liquidity. And this is great for the liquidity demanders – for example a pension fund that has to invest a recent inflow – because they don’t have to move prices very far to elicit the other side of the trade. And that means lower price volatility.

The lower volatility in turn leads to higher leverage. One reason is that many funds base their leverage on value at risk, and they calculate value at risk using historical volatility. So when there is lower volatility they can lever more and still stay within their VaR limits. A second reason is that as more capital flows into the market and as leverage increases, there is more money chasing opportunities. Alpha from the opportunities is thus dampened, so a hedge fund now has to leverage up more in order to try to generate its target returns. And so the cycle goes – more leverage leads to more liquidity and lower volatility and narrower opportunities, which then leads to still higher leverage. This cycle is not much different than the classical credit cycle – which it is a part of this time around – where financial institutions make credit successively easier and easier because of competitive pressure and an environment that has, up to that point, been clear sailing.

This then gets to the higher risk. Because the real risk in the markets is not the day-to-day volatility, it is the risk of a crisis. And as I argue in A Demon of Our Own Design, high leverage is one root cause of crisis.

Bernanke has said the hedge funds “provide a good deal of liquidity in the markets and help the markets work more efficiently.” And that should be good, right? Well, it depends on how they are getting that liquidity. If it is through leverage, there may be a cloud inside that silver lining.

This relationship between liquidity, volatility versus risk is hard to observe, because there is nothing in the day-to-day markets to suggest anything is wrong. In fact, with volatility low, everything looks just great. We don’t know that leverage has increased, because nobody has those numbers. We don’t know how much liquidity will be forthcoming if there is a market stress, nor do we know how many of those who are the liquidity providers in the normal, quiet market times will move to the sidelines, or turn into liquidity demanders themselves. On the surface, the water may be smooth as glass, but we cannot fathom what is happening in the depths.

Friday, August 17, 2007

Blowing Up the Lab on Wall Street -- Time Magazine

I was asked to write a column for Time Magazine on what is causing the subprime mortgages to have so broad an impact. Since you can see it there via the link, I am not also putting it here. But comments here are welcome. (To make a comment, click on the title so that the post appears on its own page).

Thursday, August 16, 2007

Creating a Differentiated Quantitative Hedge Fund Product

One part of the solution to the quant hedge fund problem is to use a strategy no one else is using. (The other part, in case you are wondering, is not to lever so much). Of course, it is hard to know if you are really differentiated from what other quant shops are doing – it is not like everyone gets together and presents papers at hedge fund symposiums. But, in any case, I think this is hard to accomplish.

The reason I think this is for the same reason the quant funds ended up with very similar strategies in the first place: they use the scientific method.

The key to the success of the scientific method is the reproducibility of results. If you do the same experiment I do, you will reach the same conclusion. More than that, if you and I start with the same hypothesis and apply the same data, you will discover what I discover. That is why we see so many races for the prize in the pure sciences. Even with the spectacular discovery by Watson and Crick, there were others nipping at their heels.

With the quant funds, we have well-trained professionals applying the scientific method to capture anomalies in the market. Most are trained at the same handful of institutions, they have read the same academic literature, and they are applying the same statistical tests, using the same analytical tools, to the same sets of data. So it is no surprise they come up with similar models.

That is not to say you can’t be successful doing this sort of thing. Think of Jim Simmons and Renaissance. Granted his longer-term fund has been in the same boat as Goldman and others, but his high frequency fund has made money with uncanny consistency for years. But he has a number of things working for him. First of all, he has huge scale; there are about two hundred top-notch scientists in his firm. He also has had years to amass a proprietary knowledge base, so he does not need to rely as heavily on the existing academic research. So it is reasonable to think he could stay ahead of the curve – others might get to where he has been, but by then he is another step ahead.

Saturday, August 11, 2007

What’s Going On with the Quant Hedge Funds?

There are a host of very large and well-managed quantitative equity funds that are up against the ropes, all seeing big losses at the same time. And these are market neutral funds that spend a lot of time and resources monitoring risk and systematic exposure. They try to avoid taking market bets. They also try to avoid large exposure to other systematic factors like interest rates or credit spreads. Yet they are all getting hammered. Why is this happening?

If I were to venture a guess – and it can only be a guess, because I do not know the internal workings of these funds – I would look at three culprits.

First, quantitative funds are highly levered. The modus operandi for quant funds is to find small price anomalies and turn them into meaningful returns by applying a lot of leverage, so they end up with many times the leverage of most fundamentally-driven equity hedge funds. As I point out in my book, leverage is the raw material for just about every market crisis. When a fund is highly levered and things start to go bad, it might get a call from its prime broker informing it that its collateral has dropped to the point that it no longer have enough assets to meet the required haircuts. If that happens, the fund – and others who are in the same boat – will be forced to start selling assets to reduce exposure. The selling drops prices, so the collateral declines further, forcing yet more sales. And so goes the downward cycle.

Second, they have strategies in common. This should not be surprising, given that many of these funds share a common lineage: Goldman’s Global Alpha Fund and AQR; Tyke and DE Shaw. The bread and butter strategies for many of these larger quant funds are momentum and stock valuation, with some factor-based allocation strategies sprinkled in. There aren’t a whole lot of different ways to measure momentum, so what one firm considers a high momentum stock is likely to have been similarly tagged by other firms in the game. The same is true with stock valuation and factor strategies. Valuation is modeled using factors like free cash flow, earnings quality and analysts’ earnings estimates. While there may be nuances in how you do this, you can only twist these sorts of data around so much. So at the end of the day each of these funds will be long and short similar sorts of stocks – if not the exact same stocks.

Finally, in aggregate these quant funds may be operating beyond the capacity of the markets. Well, right now that is pretty much true by definition, since it seems they can’t get out of each other’s way while they try to liquidate. But even during less crisis-prone times, the money employed by these strategies might be more than the market can absorb. One indicator of a capacity problem is the performance of these funds over the last few years. They have not been doing very well, which suggest there might be too much money chasing the opportunities. And it might be that their alpha has been dropping even as they have been increasing their leverage. If so, then the market opportunities are drying up even more than the performance would suggest. Hedge funds have to measure capacity – how much money they can effectively put in a strategy – by looking at the total capital being applied to the strategy they are pursuing, not just what they are putting to work in their fund. You need to take all of the quant funds employing the momentum-cum-valuation strategies and multiply their capital by the leverage they employ, and only then start asking the capacity question.

The quant fund crisis is as close as it gets to a pure example of the point in my book that it is liquidity and market dynamics, not economics, that spawns market crises. These are funds that invest substantially in talent and systems, and focus on keeping clear of anything systematic. Yet they are embroiled in a liquidity crisis. If it can happen to them, it can happen to anyone.

Monday, August 6, 2007

Do Credit Derivatives Increase Risk?

Credit derivatives may be altering market dynamics in a way that makes these derivatives and the bonds that underlie them riskier than we think. In particular, bonds may become more correlated than in the past because credit derivatives, rather than fundamentals and default probabilities, are driving their prices. Higher correlation may become most marked during a credit-based event. Investors who have to reduce their derivatives exposure or who have to hedge their exposure by taking positions in the underlying bonds will look at the bonds as part of a CBO package, and the bonds in that package will move in lockstep.

Rating agencies do not consider this new dynamic, so the ratings underestimate risk. If a set of A-rated bonds are put in a portfolio, the principle of diversification leads that portfolio to be less risky than the individual bonds. And the lower the correlation between the bonds, the lower the risk. Historically, bonds are not very correlated when it comes to default, so a rating agency that relies on historical data might come to the conclusion that the portfolio of bonds has low enough risk to merit an AAA rating. But if there is a credit derivative-based crisis, those bonds will become more correlated for no reason other than that they are bound into the same derivative instruments.

Things might only get worse when the rating agencies come around to marking these instruments correctly, because they will likely do so at the least opportune time. I don’t think they will wake up and start to revise ratings based on abstract arguments concerning market dynamics and the effect derivatives might play on the linkages between bonds. Instead, they will wake up when the market finally manifests the level of risk these instruments really contain; that is, when a crisis hits and the higher correlation becomes evident. So at the worst possible time, ratings may be revised and push many of these derivatives over the edge – either the A-rated or the investment-grade threshold. Many investors with ratings restrictions on their portfolios will be forced to liquidate these positions. The result will be a crisis laid upon another crisis.